Money, Banking and Financial Markets- Chapter 13 (Central Banks and the Federal Reserve System)

Structure of the Federal Reserve System

Unique separation on power

-diffused among geographical areas, private sectors, government, public, bankers and business

Created 1913 as response to bank panics

-panic of 1907

-Federal Reserve Act of 1913

Structure consists of

-Federal Reserve Banks

-Board of Governors

-Federal Open Market Committee

Board of Governors

7 members appointed by President & confirmed by Senate

Headquarters in Washington D.C.

Chair of the Board:

-advises the President on economic policy

-testifies in Congress

-speaks to media

Board of Governors (Monetary policy tools)

Set reserve requirements

Control discount rate

Approve/disapprove discount rate established by FRBs

Vote on conduct of open market operations

(including 5 presidents of district banks)

12 Federal Reserve Banks (FRBs)

Federal Reserve Act of 1913 defines 12 districts

-boundaries based on population & economic considerations

Per district

-one main FRB

-at least one branch office

Federal Reserve Bank Functions

Clear checks

Issue new currency & remove damaged currency

Conduct research related to monetary policy & collect data

Perform bank examinations

12 Federal Reserve Banks

Quasi-public institutions (owned by private commercial member banks)

9 directors:

-A directors (professional bankers)

-B directors (leaders from industry, labor, agriculture, consumer sector)

-C directors (appointed by Board, in the public interest)

FOMC

Makes decisions regarding open market operations to influence monetary base (supply).

Chairman of Board of Governors is also chair of this committee.

In charge of open market operations (OMOs)

-arguably most important Fed tool for controlling money supply

Federal funds rate

Rate at which banks borrow from one another (overnight loan).

FOMC

Meets 8 times a year to discuss:

-economic forecasts

-monetary policy

-findings from business/financial institution surveys ("beige book")

Expansionary Monetary Policy

Easing of monetary policy

Increase of money supply

Decrease in federal funds rate

Contractionary Monetary Policy

Tightening of monetary policy

Decrease in money supply

Increase in federal funds rate

How independent is the Fed?

Instrument independence: ability of central bank to set monetary policy instruments

Goal independence: ability of central bank to set the goals of monetary policy

(evidence suggests Fed is free along both dimensions)

Pro Fed independence

-avoid political pressure since it adds inflationary bias to monetary policy

-politicians usually look at short-term goals only

in sr, high money growth leads to lower interest rates

in lr, causes high inflation

-politicians have shown repeated inability to make hard choices for the good of the economy

Political business cycle

Product of successful political pressure

1. expansionary monetary policy leads to lower unemployment and lower interest rates (good idea right before elections)

2. (post-election) higher inflation, which then leads to higher interest rates (hopefully disappeared/forgotten by next election)

Anti Fed independence

-undemocratic

-lack of accountability (Fed goes unpunished if it performs badly)

-difficult to coordinate fiscal and monetary policy

-has not used its independence successfully

Empirical evidence

-suggests higher independence of central bank improves country's economic performance

-countries with more independent cbs tend to have lower inflation rates at no higher output fluctuations or higher unemployment